Can FASB Simplify Evaluation of Debt vs. Equity Classification?

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Determining the proper classification can be complicated for financial instruments that have characteristics of both debt and equity, i.e., convertible debt. Financial statement preparers have long lamented the complexity of existing guidance, and incorrect conclusions have led to a high number of financial statement restatements. Over the last 30 years, FASB has made six attempts to overhaul its guidance in this area with limited success. FASB recently released an exposure draft that would make targeted changes to the guidance on convertible instruments and the derivative scope exception for contracts in an entity’s own equity. Comments on the proposal are due by October 14, 2019.

Convertible Instruments

Convertible Instruments

FASB’s proposal would reduce the number of accounting models available for convertible debt securities from five to two, which would result in fewer embedded conversion features being separately recognized from the host contract and the interest rate of more convertible debt instruments being closer to the coupon interest rate. The proposal includes updates to the disclosures for convertible instruments and earnings-per-share (EPS) guidance. For convertible instruments, the instruments primarily affected would be those issued with substantial premiums, beneficial conversion features or cash conversion features because the accounting models for those specific features would be removed. The changes in the disclosure requirements would affect all entities that issue convertible instruments.

Current Models versus Proposed Models

Derivatives Scope Exception

Currently, an entity must determine whether a contract qualifies for a scope exception from derivative accounting using the following two criteria:

  • The contract is indexed to an entity’s own stock (referred to as the indexation guidance), and
  • The contract is equity classified (referred to as the settlement guidance)

If both of those criteria are not met, the contract must be recognized as an asset or liability. FASB notes the strict application of the derivatives scope exception guidance results in accounting for some contracts as derivatives while economically similar contracts are accounted for as equity. The proposal would amend guidance for the derivatives scope exception for contracts in an entity’s own equity as follows:

  • Allow an entity to qualitatively screen out any contingent events that are considered to have a remote likelihood of occurring and disregard these events in the assessment of the derivatives scope exception, and
  • Remove three conditions required to qualify for the settlement guidance related to settlement in unregistered shares, collateral requirements and shareholder rights

These changes would reduce form-over-substance-based accounting conclusions that are driven by remote contingent events and would provide immediate relief for private companies and small public companies that continue to have errors in their financial statements because of the form-based (or rules-based) accounting requirements. The proposed ASU also would improve and amend the related disclosure and EPS guidance.

For contracts in an entity’s own equity, the contracts primarily affected would be freestanding instruments and embedded features that are accounted for as derivatives under the current guidance because of form-over-substance-based accounting conclusions, i.e., contracts with certain remote settlement features would no longer be required to be accounted for as derivatives.

For additional information, contact your BKD trusted advisor or visit our website.

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